a

GAO

United States General Accounting Office

Report to the Chairman, Committee on 

Financial Services, House of 

Representatives

September 2002 CATASTROPHE 

INSURANCE RISKS

The Role of 

Risk-Linked Securities 

and Factors Affecting 

Their Use

GAO-02-941
Page i GAO-02-941 Risk-Linked Securities

Contents

Letter 1

Results in Brief 3

Background 6

Insurance and Reinsurance Markets Provide Catastrophe Risk 

Coverage and Capital Markets Add to Industry Capacity 8

Risk-Linked Securities Have Complex Structures 18

Regulatory, Accounting, Tax, and Investor Issues Might Affect Use of 

Risk-Linked Securities 22

Agency Comments and Our Evaluation 30

Appendixes

Appendix I: Scope and Methodology 33

Appendix II: Catastrophe Options 36

Appendix III: California and Florida Approaches to Catastrophe Risk 37

California Earthquake Authority Provides Insurance 37

Florida Provides Residential Coverage for Windstorms and 

Supplements Insurance Capacity 38

Appendix IV: Statutory Accounting Balance Sheet Implications of 

Reinsurance Contracts 41

Appendix V: Comments from the National Association of Insurance 

Commissioners 44

Appendix VI: Comments from the Reinsurance Association of America 46

GAO Comments 49

Appendix VII: Comments from the Bond Market Association 50

GAO Comments 58

Figures Figure 1: Catastrophic Risk in the United States: Earthquake, 

Hurricane, Tornado, and Hail 10

Figure 2: Estimated Losses from Recent Large Catastrophes 12

Figure 3: Traditional Insurance, Reinsurance, and Retrocessional 

Transactions 13

Figure 4: U.S. Reinsurance Prices, 1989-2001 14

Figure 5: Special Purpose Reinsurance Vehicle 19

Figure 6: Current and Proposed California Earthquake Authority 

Financial Structure 38

Figure 7: Effect on Ceding and Reinsurance Companies’ Balance 

Sheets before and after a Reinsurance Transaction 42
Contents

Page ii GAO-02-941 Risk-Linked Securities

Abbreviations

BMA Bond Market Association

CBOT Chicago Board of Trade

CEA California Earthquake Authority

CFTC Commodity Futures Trading Commission

EITF Emerging Issues Task Force

FASB Financial Accounting Standards Board

FASIT Financial Asset Securitization Investment Trust

FHCF Florida Hurricane Catastrophe Fund

FWUA Florida Windstorm Underwriting Association

GAAP Generally Accepted Accounting Principles

JUA Florida Residential Joint Underwriting Association

LIBOR London Interbank Offered Rate

NAIC National Association of Insurance Commissioners

PCS Property Claim Services

RAA Reinsurance Association of America

REMIC Real Estate Mortgage Investment Conduit

SEC Securities and Exchange Commission

SPE special purpose entity

SPRV special purpose reinsurance vehicles
Page 1 GAO-02-941 Risk-Linked Securities

United States General Accounting Office

Washington, D.C. 20548

A

September 24, 2002 Letr

The Honorable Michael G. Oxley

Chairman, Committee on Financial Services

House of Representatives

Dear Mr. Chairman:

Because of population growth, resulting real estate development, and rising 

real estate values in hazard-prone areas, our nation is increasingly exposed 

to much higher property-casualty losses—both insured and uninsured—

from natural catastrophes than in the past.1

 In the 1990s, a series of natural 

disasters, including Hurricane Andrew and the Northridge earthquake, (1) 

raised questions about the adequacy of the insurance industry’s financial 

capacity to cover large catastrophes without limiting coverage or 

substantially raising premiums and (2) called attention to ways of raising 

additional sources of capital to help cover catastrophic risk. The nation’s 

exposure to higher property-casualty losses increases pressure on federal, 

state, and local governments; businesses; and individuals to assume everlarger liabilities for losses associated with natural catastrophes. 

Recognizing this greater exposure and responding to concerns about 

insurance market capacity, participants in the insurance industry and 

capital markets have developed new capital market instruments (hereafter 

called risk-linked securities)2

 as an alternative to traditional propertycasualty reinsurance, or insurance for insurers. 

Because of these concerns, you asked that we review the role of risk-linked 

securities in providing coverage for catastrophic risk and issues related to 

their expanded use. As agreed with your office, our objectives were to (1) 

describe catastrophe risk and how the insurance and capital markets 

provide for coverage against such risks; (2) describe how risk-linked 

securities, particularly catastrophe bonds, are structured; and (3) analyze 

how key regulatory, accounting, tax, and investor issues might affect the 

1

In this report, we use the term “catastrophe risk” to mean risk from natural catastrophes. 

For a discussion of insurance issues surrounding terrorism, see U.S. General Accounting 

Office, Terrorism Insurance: Alternative Programs for Protecting Insurance Consumers, 

GAO-02-175T (Washington, D.C.: Oct. 24, 2001).

2

In this report, we refer to capital market instruments that cover insured catastrophe risks 

as “risk-linked securities,” even though some of these instruments are not securities in the 

formal sense.
Page 2 GAO-02-941 Risk-Linked Securities

use of risk-linked securities. Our overall objective was to provide the 

Committee with information and perspectives to consider as the 

Committee and Congress move forward in this important and complex 

area. 

Even though we did not have statutory audit or access to records authority 

with private-sector entities, we obtained extensive documentary and 

testimonial evidence from a large number of entities, including insurance 

and reinsurance companies, investment banks, institutional investors, 

rating agencies, firms that develop models to analyze catastrophe risks, 

regulators, and academic experts. We did not verify the accuracy of data 

provided by these entities. Some entities with whom we met voluntarily 

provided information they considered to be proprietary; therefore, we did 

not report details from such information. In other cases companies decided 

not to voluntarily provide proprietary information, and this limited our 

inquiry. For example, we did not obtain any reinsurance contracts 

representing either traditional reinsurance or reinsurance provided 

through the issuance of risk-linked securities. 

Although we identified factors that industry and capital markets experts 

believe might cause the use of risk-linked securities to expand or contract, 

we make no prediction about the future use of these securities—either 

under current accounting, regulatory, and tax policies or under changed 

policies. Nor are we taking a position that increased use of risk-linked 

securities is beneficial or detrimental. Appendix I provides a detailed 

discussion of our scope and methodology. 

We conducted our work between October 2001 and August 2002 in 

Washington, D.C.; Chicago, Ill.; New York, N.Y.; and various locations in 

California and Florida in accordance with generally accepted government 

auditing standards. Written comments on a draft of this report from the 

National Association of Insurance Commissioners (NAIC),3

 the 

Reinsurance Association of America (RAA),4

 and the Bond Market

3

NAIC is a voluntary organization of the chief insurance regulatory officials of the 50 states, 

the District of Columbia, and four U.S. territories. 

4

RAA is a national trade association representing property and casualty organizations that 

specialize in reinsurance. 
Page 3 GAO-02-941 Risk-Linked Securities

Association (BMA) 5 appear in appendixes V, VI, and VII, respectively. We 

also obtained technical comments from the Department of the Treasury 

(Treasury), the Securities and Exchange Commission (SEC), the 

Commodities Futures Trading Commission (CFTC), NAIC, RAA, and BMA 

that have been incorporated where appropriate. 

Results in Brief Catastrophe risk includes exposure to losses from natural disasters, such 

as hurricanes, earthquakes, and tornadoes, which are infrequent events 

that can cause substantial financial loss but are difficult to reliably predict. 

The characteristics of natural disasters prompt most insurers to limit the 

amount and type of catastrophe risk they hold. For example, propertycasualty insurers that hold policies on their books that are overly 

concentrated in certain states, such as California and Florida, typically 

diversify and transfer risk through reinsurance.6

 Traditional reinsurance 

depends, in part, on well-developed contractual and business relationships 

between insurers and reinsurers. These relationships facilitate relatively 

low transaction costs and indemnity-based coverage, which compensates 

insurers for part or all of their losses from insured claims.7

 However, in the 

case of extremely large or multiple catastrophic events, insurers might not 

have purchased sufficient reinsurance, or traditional reinsurance providers 

might not have sufficient capital to meet their existing obligations. In any 

event, after a catastrophic loss, reinsurance capacity may be diminished 

and reinsurers might raise prices or limit availability of future catastrophic 

reinsurance coverage. In the 1990s, the combination of Hurricane Andrew 

and the Northridge earthquake along with reinsurance market conditions 

helped spur the development of capital market instruments and other 

alternatives to traditional reinsurance, such as state-run programs. Yet to 

date, risk-linked securities have represented a small share of the overall 

5

BMA represents securities firms and banks that underwrite, distribute, and trade fixed 

income securities, both domestically and internationally.

6

Reinsurance is insurance for insurers that enables the insurer to transfer some of its risk to 

another insurer, called a reinsurer. 

7

Indemnity coverage specifies a simple relationship that is based on the insurer’s actual 

incurred claims. For example, an insurer could contract with a reinsurer to cover half of all 

claims—up to $100 million in claims—from a hurricane over a specified time period in a 

specified geographic area. If a hurricane occurs where the insurer incurs $100 million or 

more in claims, the reinsurer would pay the insurer $50 million. In contrast, nonindemnity 

coverage specifies a specific event that triggers payment and payment formulas that are not 

directly related to the insurer’s actual incurred claims. 
Page 4 GAO-02-941 Risk-Linked Securities

property-casualty reinsurance market. According to the Swiss Reinsurance 

Company, in 2000, risk-linked securities represented less than 0.5 percent 

of the worldwide catastrophe insurance. 

Risk-linked securities that can be used to cover risk from natural 

catastrophes employ many structures and include catastrophe bonds and 

catastrophe options. Currently, most risk-linked securities are catastrophe 

bonds. The cost of issuing catastrophe bonds includes the legal, 

accounting, and information costs necessary to issue securities and market 

them to investors who do not have contractual or business relationships 

with the insurance company receiving coverage. Although catastrophe 

bonds generally involve higher transaction costs than traditional 

reinsurance and most recently issued bonds have not been indemnitybased, they provide broader access to national and international capital 

markets. To provide catastrophe coverage via a catastrophe bond, an 

investment bank or insurance broker creates a special purpose reinsurance 

vehicle (SPRV) to issue bonds to the capital markets and to provide the 

sponsor organization—typically an insurance or reinsurance company—

with reinsurance. The SPRVs are typically located offshore for tax, 

regulatory, and legal advantages. The SPRVs that issue catastrophe bonds 

receive payments in three forms (insurance premiums, interest payments, 

and principal payments); invest in Treasury securities and other highly 

rated securities; and pay investors in another form (interest). If the 

catastrophe occurs, principal that otherwise would be returned to the 

investors is used to fund the SPRV’s payments to the insurer. The investor’s 

reward for taking risk is a relatively high interest rate paid by the bonds. On 

the one hand, insurers prefer indemnity coverage, because the amount that 

the reinsurer pays will be directly linked to the insured claims actually 

incurred. However, that means the reinsurer has to pay more if the insurer 

underwrites (i.e., selects risks) poorly. On the other hand, investors cannot 

monitor the insurer’s behavior as well as the traditional reinsurer can, thus 

investors have greater exposure to risk from poor underwriting. Therefore, 

catastrophe bond issuers have developed nonindemnity-based bonds. 

Recently issued catastrophe bonds have been structured to make payments 

to the sponsor upon the occurrence of specified catastrophic events that 

can be objectively verified, such as an earthquake reaching 7.2 or higher in 

moment magnitude.8

8

Moment magnitude, a measure of earthquake intensity similar to the more commonly 

known Richter scale, has been used in catastrophe bonds securitizing earthquake risk.
Page 5 GAO-02-941 Risk-Linked Securities

We identified and analyzed regulatory, accounting, tax, and investor issues 

that might affect the use of risk-linked securities. First, NAIC and insurance 

industry representatives are considering revisions in the regulatory 

accounting treatment of risk transfer obtained from nonindemnity-based 

coverage that would allow credit to the insurer similar to that now afforded 

traditional (indemnity-based) reinsurance. Such a revision, if adopted, has 

the potential to facilitate the use of risk-linked securities. Nevertheless, it is 

important yet difficult for U.S. insurance regulators to develop an effective 

measure to account for risk reduction for nonindemnity-based coverage so 

that insurance company filings with respect to risk evaluation and capital 

treatment both properly reflect the risk retained. Second, the Financial 

Accounting Standards Board (FASB) is proposing a new U.S. Generally 

Accepted Accounting Principles (GAAP) interpretation, which would 

increase independent capital investment requirements that allow the 

sponsor to treat SPRVs and similar entities as independent entities and 

report SPRV assets and liabilities separately. While the proposed guidance 

is intended to improve financial transparency in capital markets, it also 

could increase the cost of issuing catastrophe bonds and make them less 

attractive to sponsors. If the proposed rule were implemented, sponsors 

might turn to risk-linked securities such as catastrophe options that do not 

require an SPRV.9

 

Third, “pass-through” tax treatment—which eliminates taxation at the 

SPRV level—with favorable implementing requirements could facilitate 

expanded use of catastrophe bonds, but such legislative actions may also 

create pressure from other industries for similar tax treatment. It is not 

clear if and when regulatory, accounting, and tax issues will be resolved. 

Fourth, catastrophe bonds, most of which are noninvestment-grade 

instruments, have not been sold to a wide range of investors beyond 

institutional investors. Investment fund managers whose portfolios include 

catastrophe bonds told us that these bonds comprise 3 percent or less of 

their portfolios. On the one hand, the managers appreciate the 

diversification aspects of catastrophe bonds because the risks are generally 

uncorrelated with the credit risks of other parts of the bond portfolio. On 

the other hand, the risks are difficult to assess and the bonds have a limited 

track record. If the ability of investors to evaluate the risks and rewards of 

risk-linked securities improves, or if catastrophe reinsurance price and 

availability becomes problematic, the risk-linked securities market has the 

potential to expand. 

9

See appendix II for a discussion of catastrophe options.
Page 6 GAO-02-941 Risk-Linked Securities

This report does not contain any recommendations. We obtained 

comments on a draft of this report which are discussed on pages 30 to 32.

Background Natural catastrophes have a low probability of occurrence, but when they 

do occur the consequences can be of high severity. Insurance companies 

face catastrophe risk associated with their provision of property-casualty 

insurance. Major reinsurers are insurance companies with global insurance 

and reinsurance operations. Insurers and reinsurers are subject to “moral 

hazard,” which is “the incentive created by insurance that induces those 

insured to undertake greater risk than if they were uninsured, because the 

negative consequences are passed through to the insurer.” Therefore, 

reinsurers have incentives to limit the possibility that ceding insurers take 

actions that would create negative consequences for the reinsurer. 

Indemnity reinsurance contracts have the potential to increase a reinsurer’s 

risk exposure to the extent that the reinsurer might be unaware of the 

underwriting and claims settlement practices of the ceding insurer.

Traditional reinsurance is generally indemnity-based and tailored to the 

needs of the ceding company because traditional reinsurance depends, in 

part, on well-developed contractual and business relationships between 

insurers and reinsurers. When reinsurance coverage is not indemnitybased, the ceding insurer is exposed to basis risk—the risk that there may 

be a difference between the payment received from the reinsurance 

coverage and the actual accrued claims of the ceding insurance company. 

Property-casualty reinsurance agreements are typically single-event, 

excess of loss contracts. A single-event contract means that the reinsurer’s 

obligations are specific to an event, such as a hurricane in a contractually 

specified geographic area. Excess of loss means that the reinsurer makes 

payments that are based on a contractually specified share of claims in 

excess of a minimum amount, subject to a maximum claim payment. 
Page 7 GAO-02-941 Risk-Linked Securities

The financial industry has developed instruments through which primary 

financial products, such as lending or insurance, can be funded in the 

capital markets. Lenders and insurers continue to provide the primary 

products to the customers, but these financial instruments allow the 

funding of the products to be “unbundled” from the lending and insurance 

business; instead, the funding comes from securities sold to capital market 

investors. This process, called securitization, can give insurers access to 

the large financial resources of the capital markets.10 With respect to 

funding catastrophe risk in property-casualty insurance, the risk of 

investing is tied to the potential occurrence of a specified catastrophic 

event and to the quality of underwriting by insurers and reinsurers.

In evaluating risk, capital market investors face the issue of moral hazard 

because in the absence of well-developed contractual and business 

relationships with primary market insurers, capital market investors might 

be unable to monitor the primary insurance company’s underwriting and 

claims settlement practices that can act to increase risk. Nonindemnitybased coverage is a means to limit moral hazard for the investor by tying 

payment to industry loss indexes, parametric measures, and models of 

claims payments rather than actual claims that could be affected by lax 

underwriting standards or lax settlement of claims by the ceding insurer. 

However, such coverage introduces basis risk for the sponsoring insurance 

company.11

Insurance companies are not regulated at the federal level but are to 

comply with the laws of the states in which they operate. The insurance 

regulators of the 50 states, the District of Columbia, and U.S. territories 

have created NAIC to coordinate regulation of multistate insurers. NAIC 

serves as a forum for the development of uniform policy, and its 

committees develop model laws and regulations governing the U.S. 

insurance industry. Although not required to do so, most states either adopt 

model laws or modify them to meet their specific needs and conditions. 

10To illustrate the size of U.S. capital markets, we used Federal Reserve Board Flow of 

Funds data for the quarter ended March 31, 2002. Our calculation indicated that the size of 

the U.S. capital markets was about $31 trillion. We included outstanding levels of U.S. 

Treasury securities (excluding savings bonds), agency securities, municipal securities, 

corporate and foreign bonds, and corporate equities. 

11Basis risk is the possibility that the value of a hedge will not move precisely with the value 

of the item being hedged. For catastrophe risk, basis risk is the risk that, for example, the 

value of a catastrophe option will not move precisely with the insurer’s catastrophe loss 

experience.
Page 8 GAO-02-941 Risk-Linked Securities

NAIC also has established statutory accounting standards, which are 

intended for use by insurance departments, insurers, and auditors when 

state statutes or regulations are silent. If not in conflict with state statutes 

and regulation, or in cases when the state statutes are silent, statutory 

accounting standards promulgated by NAIC are intended to apply. In 

addition to statutory accounting standards, insurers use GAAP, which are 

promulgated by FASB and are designed to meet the varying needs of both 

insurance and noninsurance companies. Although NAIC’s statutory 

accounting standards use the framework established by GAAP, GAAP 

stresses the measurement of earnings from period to period, while NAIC’s 

standards stress the measurement of ability to pay claims in the future. 

NAIC has also developed the Risk-Based Capital for Insurers Model Act, 

adopted in some form in all states, which imposes automatic requirements 

on insurers to file plans of action when their capital falls below minimum 

standards. 

Insurance and 

Reinsurance Markets 

Provide Catastrophe 

Risk Coverage and 

Capital Markets Add to 

Industry Capacity

Natural catastrophes are infrequent events that can cause severe financial 

losses. Traditional reinsurance helps insurance companies respond to 

severe losses by limiting their individual liability on specific risks and 

thereby increases individual insurers’ capacity. However, insurance 

companies have been faced with higher reinsurance premiums for certain 

coverage following significant past natural catastrophes. Higher costs of 

reinsurance helped spur the development of risk-linked securities as an 

alternative to traditional reinsurance. 

Natural Catastrophes Are 

Infrequent Events but Cause 

Severe Loss 

Although natural catastrophes occur relatively infrequently compared with 

other insured events, they can affect large numbers of persons as well as 

their property. The U.S. property and casualty insurance12 industry has 

paid, on average, $9.7 billion in catastrophe-related claims per year from 

1989 through 2001, and the amount of claims paid can be highly variable. 

More than 68 million Americans now live in hurricane-vulnerable coastal 

areas. Eighty percent of Californians live near active faults. When natural 

disasters occur they cause damage and destruction, which may or may not 

12Property-casualty insurance protects individuals and commercial businesses against the 

risks associated with the loss of property from fire and other hazards, or loss deriving from 

liability for personal injury and damage to the property of others. Property-casualty 

insurance includes damage to real estate, automobiles, glass, and other items.
Page 9 GAO-02-941 Risk-Linked Securities

be covered by insurance. The four most costly types of insured 

catastrophic perils in the United States are earthquakes, hurricanes, 

tornadoes, and hailstorms, although earthquakes and hurricanes pose the 

most significant catastrophe risk in insurance markets. Figure 1 shows the 

combined relative risk of these hazards across the United States.
Page 10 GAO-02-941 Risk-Linked Securities

Figure 1: Catastrophic Risk in the United States: Earthquake, Hurricane, Tornado, and Hail

Note: Risk is depicted as average annual loss at a given location from a broad range of catastrophic 

events. Losses from fires following earthquakes are not included. Because flood-related losses are 

largely covered by the National Flood Insurance Program, flooding and coastal storm surges are not 

included. 

Source: Risk Management Solutions.
Page 11 GAO-02-941 Risk-Linked Securities

In August 1992, Hurricane Andrew swept ashore in Florida south of Miami 

and at the time set a new record for insured losses. As shown in figure 2, 

estimated losses from Andrew were about $30 billion, of which $15.5 billion 

was insured. Payments of claims stemming from Andrew reduced the 

capital of affected insurance companies and sharply reduced their capacity 

to issue new policies. Some of Florida’s largest homeowner insurance 

companies had to be rescued by their parent companies and others had to 

tap their surpluses to pay claims. Eleven property-casualty insurance 

companies went into bankruptcy. In January 1994, an earthquake occurred 

about 20 miles northwest of downtown Los Angeles in the Northridge area 

of the San Fernando Valley. Also shown in figure 2, estimated losses from 

the Northridge earthquake were about $30 billion, of which approximately 

$12.5 billion was insured. Earthquake insurance coverage availability 

declined precipitously after the Northridge earthquake. Losses from the 

Kobe, Japan, earthquake and the September 11, 2001, terrorist attack on the 

World Trade Center also are included in figure 2 to illustrate the global 

nature of the insurance capacity problem and to provide perspective on the 

size of losses.
Page 12 GAO-02-941 Risk-Linked Securities

Figure 2: Estimated Losses from Recent Large Catastrophes

Note: Dollar figures are estimates of insured, uninsured, and total loss.

Sources: Insurance Information Institute and other insurance industry sources.
Page 13 GAO-02-941 Risk-Linked Securities

Catastrophe Risk Is Usually 

Covered through Insurance, 

Reinsurance, and 

Retrocession

For many individuals and organizations, insurance is the most practical and 

effective way of handling a major risk such as a natural catastrophe. By 

obtaining insurance, individuals and organizations spread risk so that no 

single entity receives a financial burden beyond its ability to pay. But 

catastrophic loss presents special problems for insurers in that large 

numbers of those insured incur losses at the same time. Reinsurance helps 

insurance companies underwrite large risks, limit liability on specific risks, 

increase capacity, and share liability when claims overwhelm the primary 

insurer’s resources. In reinsurance transactions, one or more insurers 

agree, for a premium, to indemnify another insurer against all or part of the 

loss that an insurer may sustain under its policies. Figure 3 illustrates 

traditional insurance, reinsurance, and retrocessional transactions.13

Figure 3: Traditional Insurance, Reinsurance, and Retrocessional Transactions

Source: GAO.

Reinsurance is a global business. According to RAA, almost half of all U.S. 

reinsurance premiums were paid to foreign reinsurance companies.14

13Retrocessional coverage is reinsurance obtained by a reinsurance company when it 

transfers risk to another reinsurer. 

14According to RAA, in 2000 U.S. insurance companies paid 53.4 percent of their premiums 

to U.S. reinsurance companies and alien reinsurers received 46.6 percent of reinsurance 

premiums. Premiums paid by U.S. insurance companies to offshore companies were most 

likely to go to reinsurance companies domiciled in Bermuda, the Cayman Islands, the 

United Kingdom, Germany, and Switzerland.
Page 14 GAO-02-941 Risk-Linked Securities

Insurers Are Subject to 

Reinsurance Price Swings

Catastrophe reinsurance has experienced cycles in prices, both nationally 

and in specific geographic areas. Figure 4 presents a national reinsurance 

price index since 1989, which shows that, overall, reinsurance prices 

increased both before and after Hurricane Andrew and decreased after the 

Northridge earthquake.15

Figure 4: U.S. Reinsurance Prices, 1989-2001

Note: This figure creates a price index set equal to 100 in 1989 normalized prices. We could not obtain 

information to assess the reliability of the price data.

Source: Guy Carpenter & Company, Inc., a subsidiary of Marsh & McLennan Companies. 

15RAA commented that property catastrophe events have led to the creation of the Bermuda 

property reinsurance market that has played a major role in introducing new capacity into 

the marketplace after a major event. 
Page 15 GAO-02-941 Risk-Linked Securities

The price trend presented in figure 4 does not reflect the situations specific 

to Florida and California, where insurers refused to continue writing 

catastrophe coverage. In 1993, the Florida state legislature responded by 

establishing the Florida Hurricane Catastrophe Fund to provide 

reinsurance for insurance companies operating in Florida.16 Also, the 

Northridge earthquake raised serious questions about whether insurers 

could pay earthquake claims for any major earthquake. In 1994, insurers 

representing about 93 percent of the homeowners insurance market in 

California severely restricted or refused to write new homeowners policies. 

In 1996, the California state legislature responded by establishing the 

California Earthquake Authority (CEA) to sell earthquake insurance to 

homeowners and renters. Appendix III more fully discusses the 

mechanisms established by Florida and California to deal with the risks 

posed by such catastrophes.

In one comprehensive study analyzing the pricing of U.S. catastrophe 

reinsurance,17 the authors concluded that a catastrophic event, such as a 

hurricane, reduced capital available to cover nonhurricane catastrophe 

reinsurance, thereby affecting reinsurance prices. This finding is consistent 

with the “bundled” nature of capital investment in traditional reinsurance 

(i.e., capital investors face both the risks associated with company 

management and the various perils covered by the insurance company). 

Therefore, the finding suggests that price and availability swings for 

catastrophe reinsurance covering one peril are affected by catastrophes 

involving all other perils.18

Given the cyclic nature of the reinsurance market, investors have 

incentives to look for alternative capital sources. Hurricane Andrew and 

the Northridge earthquake provided an impetus for insurance companies 

and others to find different ways of raising capital to help cover 

16RAA commented that the private reinsurance market provides reinsurance to many 

primary companies in Florida. 

17Froot, Kenneth A. and Paul G.J. O’Connell, “The Pricing of U.S. Catastrophe Reinsurance,”

in Kenneth A. Froot, ed., The Financing of Catastrophe Risk, National Bureau of Economic 

Research Project Report, (Chicago: Univ. of Chicago Press, 1999). We did not verify the 

reliability of the data used nor the authors’ methodology. The authors relied on Guy 

Carpenter & Company pricing data for the years 1970 through 1994. 

18BMA commented that reinsurance prices in the United States are influenced by events in 

other parts of the world. 
Page 16 GAO-02-941 Risk-Linked Securities

catastrophic risk and helped spur the development of risk-linked securities 

and other alternatives to traditional reinsurance. 

Catastrophe Risk Can Be 

Transferred to Capital 

Markets

Catastrophe risk securitization began in 1992 with the introduction of 

index-linked catastrophe loss futures and options contracts by the Chicago 

Board of Trade (CBOT). For more information on catastrophe options, see 

Appendix II. Other risk-linked securities, especially catastrophe bonds, 

were created and used in the mid-1990s in the aftermath of Hurricane 

Andrew and the Northridge earthquake. During this time, traditional 

reinsurance prices were relatively high compared with other time periods. 

While the most direct means for insurance companies to raise capital in the 

capital market is issuing company stock, an investor in an insurance 

company’s stock is subject to the risks of the entire company. Therefore, an 

investor’s decision to purchase stock will depend on an assessment of the 

insurance company’s management, quality of operations, and overall risk 

exposures from all perils. In contrast, an investor in an indemnity-based, 

risk-linked security can face risk associated with the insurance company’s 

underwriting standards but does not take on the risk of the overall 

insurance (or reinsurance) company’s operations. The cost of issuing risklinked securities, such as catastrophe bonds, includes the legal, accounting, 

and information costs that are necessary to issue securities and market 

them to investors who do not have contractual and/or business 

relationships with the insurance company receiving coverage. The market 

test for a securitized financial instrument, such as a catastrophe bond, 

depends, in part, on how well investors can evaluate the probability and 

severity of loss that may affect returns from the investment.
Page 17 GAO-02-941 Risk-Linked Securities

However, the willingness of capital market investors to purchase 

instruments that securitize catastrophe risk, such as catastrophe bonds, 

and therefore the yields they will require, depends on a number of factors, 

including the investors’ capacity to evaluate risk and the degree to which 

the investment can facilitate diversification of overall investment 

portfolios.19 Demand for risk-linked securities by insurance and 

reinsurance company sponsors will depend, in part, on the basis risk faced 

and the ability of sponsors to hedge20 this basis risk.

Although issuance of risk-linked securities has been limited, many of the 

catastrophe bonds issued to date have provided reinsurance coverage for 

catastrophe risk with the lowest probability and highest financial severity. 

Insurance industry officials we interviewed told us that their use of risklinked securities has lowered the cost of some catastrophe protection. In 

addition, one official told us that the presence of risk-linked securities as a 

potential funding option has helped lower the cost of obtaining catastrophe 

protection covering low-probability, high-severity catastrophes from 

traditional reinsurers. 

According to the Swiss Reinsurance Company, in 2000, risk-linked 

securities represented less than 0.5 percent of worldwide catastrophe 

insurance and, according to estimates provided by Swiss Re and Goldman 

Sachs, between 1996 and August 2002, about $11 to $13 billion in risklinked securities had been issued worldwide.21 As of August 2002, over 70 

risk-linked securitizations had been done, according to Goldman Sachs. 

Risk-linked securities have covered perils that include earthquakes, 

19BMA commented that there are often compelling reasons for sponsors of risk-linked 

securities to use nonindemnity-based structures, including that they (1) more effectively 

shield the confidentiality of the sponsor’s underwriting criteria, (2) may provide for more 

streamlined deal structuring and deal execution, and (3) may facilitate a more rapid payout 

in response to triggering events. 

20A hedge is a strategy used to offset risk. For example, investors can hedge against inflation 

by purchasing assets that they believe will rise in value faster than inflation. 

21Estimates of the number and dollar amount of risk-linked securities vary. These estimates 

are published by various industry sources, such as investment banks, insurance brokers, 

and rating agencies. The estimates differ because some of these data, such as those for 

privately placed catastrophe bonds, are not generally available and because the sources 

differ in how they define the instruments and transactions included as risk-linked securities. 

For example, an instrument called contingent equity may be included by some sources and 

not by other sources. BMA commented that about $6 to $7 billion in catastrophe-related, 

risk-linked securities were issued during this time period. 
Page 18 GAO-02-941 Risk-Linked Securities

hurricanes, and windstorms in the United States, France, Germany, and 

Japan. 

Risk-Linked Securities 

Have Complex 

Structures

Catastrophe options offered by CBOT beginning in 1995 were among the 

first attempts to market risk-linked securities. The contracts covered 

exposures on the basis of a number of broad regional indexes that exposed 

insurers to basis risk, and trading in CBOT catastrophe options ceased in 

1999 due to lower-than-expected demand (see app. II).22 Insurance 

companies and investment banks developed catastrophe bonds, and the 

bonds are offered through the SPRVs. Recent catastrophe bonds have been 

nonindemnity-based to limit moral hazard; therefore, they expose the 

sponsor to basis risk. The SPRVs are usually established offshore to take 

advantage of lower minimum required levels of capital, favorable tax 

treatment, and a generally reduced level of regulatory scrutiny. 

Currently most risk-linked securities are catastrophe bonds. Most 

catastrophe bonds issued to date have been noninvestment-grade bonds.23

Catastrophe bonds achieved recognition in the mid-1990s. They offered 

several advantages that catastrophe options did not, among them 

customizable offerings and multiyear pricing. Catastrophe bonds, to date, 

have been offered as private placements only to qualified institutional 

buyers. 24 A catastrophe bond offering is made through an SPRV that is 

sponsored by an entity that may be an insurance or reinsurance company.25

The SPRV provides reinsurance to a sponsoring insurance or reinsurance 

company and is backed by securities issued to investors. The SPRVs are 

similar in purpose to the special purpose entities (SPE) that banks and

22For a description of other capital market instruments used to manage catastrophe risk, see 

U.S. General Accounting Office, Insurers’ Ability to Pay Catastrophe Claims, GAO/GGD00-57R (Washington, D.C.: Feb. 8, 2000). 

23Some catastrophe bonds contain tranches that have received investment grade ratings. 

BMA commented that a small but growing percentage of newly issued, risk-linked securities 

have been investment grade.

24A private placement is a sale of a security to an institutional investor that does not have to 

be registered with SEC. Here, an institutional investor is defined by Rule 144A. This SEC 

rule provides an exemption for limited secondary market trading of privately placed 

securities. 

25A noninsurance business that has catastrophe exposure can also sponsor catastrophe 

bonds through a similar entity, a special purpose vehicle.
Page 19 GAO-02-941 Risk-Linked Securities

other entities have used for years to obtain funding for their loans.26 These 

SPEs pay investors from principal and interest payments made by 

borrowers to the SPE. In contrast, the SPRVs that issue catastrophe bonds 

receive payments in three forms (premiums, principal, and interest); invest 

in securities; and pay investors in another form (interest). The SPRV 

returns the principal to the investor if the specified catastrophe does not 

occur. Figure 5 illustrates cash flows among the participants in a 

catastrophe bond.

Figure 5: Special Purpose Reinsurance Vehicle

Source: GAO.

As shown in figure 5, the sponsoring insurance company enters into a 

reinsurance contract and pays reinsurance premiums to the SPRV to cover 

26According to Federal Reserve Board Flow of Funds data, at the end of 2001, over $1.8 

trillion of loans outstanding were financed by asset-backed securities issued by such SPEs. 

The underlying loans were made to consumers, students, businesses, and homeowners 

exclusive of mortgage-backed securities guaranteed by government agencies, government 

corporations, and government-sponsored enterprises.
Page 20 GAO-02-941 Risk-Linked Securities

specified claims. The SPRV issues bonds or debt securities for purchase by 

investors. The catastrophe bond offering defines a catastrophe that would 

trigger a loss of investor principal and, if triggered, a formula to specify the 

compensation level from the investor to the SPRV. The SPRV is to hold the 

funds raised from the catastrophe bond offering in a trust in the form of 

Treasury securities and other highly rated assets.27 To avoid consolidation 

on the sponsor’s balance sheet, the trust also is to contain a minimum 

independent equity-capital investment of at least 3 percent of the SPRV’s 

assets, per GAAP. According to a rating agency official, the 3 percent equity 

capital is usually obtained from capital markets in the form of preferred 

stock. Typically, investors earn a return of the London Interbank Offered 

Rate (LIBOR)28 plus an agreed spread. The SPRV deposits the payment 

from the investor as well as the premium from the company into a trust 

account. The premium paid by the insurance or reinsurance company and 

the investment income on the trust account provide the funding for the 

interest payments to investors and the costs of running the SPRV. 

Under the terms of nonindemnity-based catastrophe bonds, for the 

sponsoring insurance company to collect part or all of the investors’

principal when the catastrophe occurs, an independent third party must 

confirm that the objective catastrophic conditions were met, such as an 

earthquake reaching 7.2 in moment magnitude as reported by the U.S. 

Geological Survey. Such nonindemnity bonds also allow the sponsor to 

continue to write new business without impacting the risk level of the bond 

and provide for faster reimbursement to the sponsor in the event of a 

catastrophe. The sponsor is exposed to basis risk because the claims on the 

investors’ principal might not fully hedge the sponsor’s actual catastrophe 

exposure. However, the sponsor has minimal credit risk—the risk of 

nonpayment in the event of the covered catastrophe—because the bond is 

fully collateralized. The SPRVs are usually established offshore—typically 

in Bermuda or the Cayman Islands—to take advantage of lower minimum

27The fixed-rate interest payments are swapped for floating-rate interest payments from a 

highly rated swap counterparty.

28LIBOR is the rate that the most creditworthy international banks charge each other for 

large loans. The SPRVs enter into interest rate swaps to exchange fixed-rate interest 

payments earned by funds invested in conservative instruments, such as U.S. government 

Treasury securities, for floating-rate interest payments, such as LIBOR.
Page 21 GAO-02-941 Risk-Linked Securities

required levels of capital, favorable tax treatment, and a generally reduced 

level of regulatory scrutiny.29

Bond rating agencies, such as Fitch, Moody’s, and Standard & Poors, 

provide bond ratings that are based on their assessment of loss 

probabilities and financial severity. Some SPRVs have issued catastrophe 

bonds in tranches having more than one risk structure.30 The rating 

agencies rate the bonds according to expected loss.31 Catastrophe bonds 

issued to date have generally received noninvestment-grade ratings 

because investors face a higher risk of loss of their principal.32 The rating 

agencies rely, in part, on the risk assessments of three major catastrophemodeling firms—the same firms are used by traditional reinsurers to help 

them understand catastrophe risk. These modeling firms rely on large 

computing capacity; sophisticated mathematical modeling techniques; and 

very large databases containing information on past catastrophes, 

population densities, construction techniques, and other relevant 

information to assess loss probabilities and financial severities. 

Catastrophe bond-offering statements to investors include rating 

information and the results from the catastrophe modeling. 

One example of a catastrophe bond is Redwood Capital I, Ltd., which is 

linked to California earthquakes. Lehman Re, a reinsurance company, is the 

sponsor of the bond. Due to the catastrophe bond structure, investors are 

exposed to potential loss of principal of about $160 million. The contract 

provides insurance for 12 months beginning January 1, 2002, covering 

specified earthquake losses to property in California. The interest rates 

promised on the principal-at-risk variable rate notes and preference shares 

are LIBOR+5.5 percent and LIBOR+7 percent. Investor losses are tied to 

29BMA commented that the principal reason risk-linked securities are organized offshore is 

to avoid entity-level taxation of those vehicles. 

30Tranches are classes of a security that have different characteristics of risks and returns. 

The issuer of a security can split the security’s scheduled cash flows into separate classes 

known as tranches. Often, one tranche of an issue has greater exposure to risk than another 

tranche, and the different rates that investors can earn on these different tranches reflect 

their different risks.

31There are some differences among rating agencies in their methodology for assigning 

ratings for some of the catastrophe risk structures. BMA commented that bonds are rated 

according to frequency of loss as well as expected loss. 

32Some catastrophe bonds contain tranches that have received investment-grade ratings and 

tranches with a noninvestment-grade rating. 
Page 22 GAO-02-941 Risk-Linked Securities

the Property Claim Services (PCS) index, an indicator of insured property 

losses for catastrophes. The issuer provides reinsurance coverage for the 

earthquake peril in California to Lehman Re, the sponsor, for triggering 

events causing industry losses that range from $22.5 billion to $31.5 billion 

as estimated by PCS. Proceeds from the issuance of the securities are to be 

deposited into a collateral account and invested in securities that are 

guaranteed or insured by the U.S. government and in highly rated 

commercial paper and other securities. The securities have been offered 

only to qualified institutional buyers as defined by SEC Rule 144A. Moody’s 

rated the bond a Ba2 (i.e., a noninvestment-grade bond rating) on the basis 

of the determination that it is comparable to a Ba2-rated conventional bond 

of similar duration. The rating took into account the risk analysis of a 

catastrophe-modeling firm. 

Regulatory, 

Accounting, Tax, and 

Investor Issues Might 

Affect Use of RiskLinked Securities

We identified and analyzed regulatory, accounting, tax, and investor issues 

that might affect the use of risk-linked securities. Our analysis included (1) 

current accounting treatment of risk-linked securities and proposed 

changes to accounting treatment, (2) potential changes in equity 

requirements for the SPRVs, (3) a preliminary tax proposal by insurance 

industry representatives to encourage domestic issuance of catastrophe 

bonds by creating “pass-through” tax treatment, and (4) reasons for limited 

investor participation in risk-linked securities.

Regulators Are 

Reconsidering Accounting 

Treatment of Risk-Linked 

Securities

Under certain conditions, NAIC’s Statutory Accounting Principles allow an 

insurance company that obtains reinsurance to reflect the transfer of risk 

(effected by the purchase of reinsurance) on the financial statement it files 

with state regulators. These regulatory requirements are designed to 

ensure that a true transfer of risk has occurred and the reinsurance 

company will be able to pay any claims.33 In receiving “credit” for 

reinsurance, an insurance company may count the payments owed it from 

the reinsurance company on claims it has paid as an asset or as a deduction 

from liability. In doing so, a company can increase earnings reported on its 

33While such requirements have been promulgated, many insurance regulators hold the view 

that it is not within their oversight responsibility to police individual reinsurance business 

transactions between insurance companies, as such transactions are between sophisticated 

parties. See U.S. General Accounting Office, Summary of Reinsurance Activities and 

Rating Actions Tied to Selected Insurers Involved in the Failed “Unicover” Venture, GAO01-977R (Washington, D.C.: Aug. 24, 2002). 
Page 23 GAO-02-941 Risk-Linked Securities

financial statement and lower the amount of capital it needs to meet riskbased capital requirements established by regulators. The ability to record 

an asset or to take a deduction from gross liability for reinsurance is 

consequent upon the transfer of risk and can strongly affect an insurance 

company’s financial condition.

Traditional reinsurance pays off on an indemnity trigger—that is, payment 

is based on the actual claims incurred by the insurance company. Some 

risk-linked securities have also provided payments from principal on an 

indemnity basis, and, under insurance accounting principles, these risklinked securities have enabled the SPRVs to provide reinsurance that has 

received what is called “underwriting accounting treatment,” thereby 

allowing the SPRV sponsor to gain credit for reinsurance. In other cases, 

recovery under a catastrophe bond may not be indemnity based and may 

rely on a financial model of the insured claims of the insurance company 

rather than on the actual claims of the company. In these cases, there is a 

risk that the modeled claims will not equal the insurance company’s actual 

claims. There are also risks that the financial model will produce a 

recovery less or greater than the companies’ incurred claims. Current 

accounting guidance requires that the contract must indemnify the 

company against loss or liability associated with insurance risk in order to 

qualify for reinsurance accounting.

However, NAIC is currently reconsidering the appropriate statutory 

accounting treatment of nonindemnity-based insurance, which would 

include risk-linked securities.34 Both exchange-traded instruments and 

over-the-counter instruments can be used to hedge underwriting results 

(i.e., to offset risk). The triggering event on a risk-linked contract must be 

closely related to the insurance risks being hedged so that the payoff is 

expected to be consistent with the expected claims, even though some 

basis risk may still exist. This correlation is known as “hedge 

effectiveness.” NAIC is currently considering how hedge effectiveness 

should be measured. Should NAIC determine a hedge-effectiveness 

measure, statutory insurance accounting standards could be changed so 

that a fair value of the contract could be calculated and recognized as an 

offset to insurance losses, hence allowing a credit to the insurer similar to 

34A white paper on the subject written by members of NAIC’s securitization subcommittee 

specifically addressed treatment of nonindemnity-based insurance derivatives, such as 

catastrophe options. However, NAIC is addressing this issue as it relates more broadly to 

risk-linked securities. 
Page 24 GAO-02-941 Risk-Linked Securities

that granted for reinsurance. If nonindemnity-based, risk-linked securities 

are accepted by insurance regulators as an effective hedge of underwriting 

results, they could help make such contracts more appealing to insurance 

companies by providing treatment similar to that afforded traditional 

reinsurance. Nevertheless, it is important yet difficult for U.S. insurance 

regulators to develop an effective measure to account for risk reduction for 

nonindemnity-based coverage so that insurance company reporting on 

both risk evaluation and capital treatment properly reflects the risk 

retained. Appendix IV contains a discussion of credit for reinsurance 

accounting treatment and the balance sheet implications of such treatment.

Proposed Rule on Equity 

Requirements Could Affect 

Catastrophe Bonds 

An SPE is created solely to carry out an activity or series of transactions 

directly related to a specific purpose. The use of an SPE (or more 

specifically an SPRV) in a catastrophe bond securitization transaction 

involves a number of complex financial accounting issues in the United 

States. Current FASB guidance generally provides that the sponsor of an 

SPE report all assets and liabilities of the SPE in its financial statements, 

unless all of the following criteria are met:

1. Independent third-party owner’s(s’) investment in the SPE is at least 3 

percent of the SPE’s total debt and equity or total assets.

2. The independent third-party owner(s) has a controlling financial 

interest in the SPE (generally meaning that the owner holds more than 

50 percent of the voting interest of the SPE). 

3. Independent third-party owners must possess the substantive risk and 

rewards of its investment in the SPE (generally meaning that the 

owner’s investment and potential return are “at risk” and not 

guaranteed by another party).35

In response to issues arising from Enron’s use of SPEs, FASB is currently 

considering a new approach to accounting for SPEs. The new FASB 

interpretation would require the primary beneficiary of an SPE to 

consolidate (list assets and liabilities of) the SPE in its financial statements, 

unless the SPE has “economic substance” sufficient not to be consolidated; 

that is, the SPE would have to have the ability to fund or finance its 

35See Emerging Issues Task Force (EITF), Topic Number D-14, Transactions Involving 

Special Purpose Entities and other related EITF issues.
Page 25 GAO-02-941 Risk-Linked Securities

operations without assistance from or reliance on any other party involved 

in the SPE. In turn, the SPE would have that ability if it had independent 

third-party owners who have substantive voting equity investment at risk, 

exposure to variable returns, and the ability to make decisions and manage 

the SPE’s activities. A presumption is set that substantive equity investment 

in an SPE should be at least 10 percent of the SPE’s total assets throughout 

the life of the SPE. Therefore, according to information provided by FASB, 

many existing SPEs would probably be consolidated on the sponsors’

financial statements under the new requirement. The potential revision for 

equity requirements is intended to improve transparency in capital 

markets. According to rating agency officials, the current 3 percent 

independent equity requirements in recent catastrophe bond transactions 

have been met by issuing preferred stock. Our work did not determine the 

extent to which the 3 percent independent equity requirement is currently 

being met by the insurance industry. 

Bond market representatives told us that the proposed FASB equity 

requirements also have the potential to create a substantial hurdle to 

structuring catastrophe bond SPEs because few investors would be willing 

to purchase preferred shares because of the difficulties in understanding 

the risks. These representatives argue that risk-linked securitizations are 

different from other securitizations using SPEs because the insurer does 

not control the funds held by the SPE, and therefore, should not be subject 

to the new 10 percent equity investment requirement. 

The proposed new FASB interpretation also considers who bears the 

largest potential risks of the SPE when determining whether to consolidate 

with the primary beneficiary. Should the primary beneficiary bear the 

largest dollar loss if the SPE should fail, then consolidation would be 

required with the primary beneficiary. According to one FASB 

representative, one issue that needs to be considered is whether the insurer 

or the investors should be responsible for reporting or consolidating the 

assets and liabilities of the SPE in financial statements depending on who 

bears the largest potential risks of the SPE. If an insurer must consolidate 

the assets and liabilities of the SPE onto its own balance sheet, the insurer 

will also lose part of the benefit of the reinsurance contract that it enters 

into with the SPE.

While the proposed guidance is intended to improve financial transparency 

in capital markets, it could also increase the cost of issuing catastrophe 

bonds and make them less attractive to sponsors. If the proposed rule were 
Page 26 GAO-02-941 Risk-Linked Securities

implemented, sponsors might turn to risk-linked securities that do not 

require an SPE, such as catastrophe options.

Insurance Industry 

Representatives Have 

Proposed Pass-Through Tax 

Treatment of Risk-Linked 

Securities

NAIC is concerned that offshore SPRVs reduce economic efficiency and 

limit the oversight ability of insurance regulators. To further encourage the 

use of onshore SPRVs, NAIC’s working group on securitization has 

interacted with a group of insurance industry representatives that is 

considering how to structure a legislative proposal to make onshore SPRVs 

tax-exempt entities. The SPRVs have been established in offshore tax 

haven jurisdictions, where the SPRV itself is not subject to any income or 

other tax; the SPRVs also usually operate in a manner intended to help 

ensure that they avoid U.S. taxation by conducting most activities outside 

of the United States.36 Taxation of the U.S. holders of SPRV-issued 

securities depends upon whether the securities are characterized as debt or 

equity. This characterization in turn depends upon a number of factors, 

including the likelihood of loss of principal, the relative degree of 

subordination of the instrument in the SPRV’s capital structure, and the 

accounting treatment of the instrument.

Although almost all SPRVs have been established offshore, there has been 

interest in facilitating the creation of onshore transactions because it is 

argued that onshore SPRVs would lessen transactional costs and afford 

regulators greater scrutiny of the SPRVs’ activities. NAIC has already 

approved a model state insurance law that allows for the creation of an 

onshore SPRV. Under the model law, an onshore SPRV would be an entity 

domiciled in and organized under state law for a limited purpose. Insurance 

regulators’ scope of authority would be limited for the SPRVs, which would 

be required to be minimally capitalized, and the domiciliary state’s laws on 

insolvency would apply to the SPRV.

However, it is likely that the onshore SPRV would be subject to federal 

income taxation, making the transaction more expensive. To further 

36The status of the SPRV for U.S. federal income tax purposes is dependent upon a number 

of factual issues. If the SPRV were determined to be engaged in a U.S. trade or business, it 

could be subject to U.S. income tax at a rate of up to 35 percent, and to a 30 percent branch 

profits tax on its income, resulting in an effective U.S. federal tax rate of up to 54.5 percent. 

This tax rate would substantially reduce the return to investors. The SPRVs are generally 

characterized as passive foreign investment companies and treat the bonds that they issue 

as equity for federal income tax purposes. See Bertil Lundqvist, Securitization of Risk of 

Loss from Future Events, 829 PLI/Comm 875, 2001.
Page 27 GAO-02-941 Risk-Linked Securities

encourage the use of onshore SPRVs, a group of industry attendees at the 

NAIC’s insurance securitization working group is considering a legislative 

proposal to make the onshore SPRVs tax-exempt. Currently, the industry 

representatives are considering using a structure that would receive tax 

treatment similar to the treatment received by an issuer of asset- or 

mortgage-backed securities. Issuers of asset-backed securities are 

generally not subject to tax on the income from underlying assets as they 

pass through the issuer to the investors in the securities. It would not be 

economical for an SPE to issue an asset-backed security if the SPE 

incurred material tax costs on the payments collected and paid over to the 

investors as taxable income. Securitizations address the problem of taxes 

in one of two ways: First, if an asset-backed security is considered debt for 

tax purposes, deductions are allowed for the interest expense, and the tax 

burden is shifted to the investors. Second, if the securities are not classified 

as debt, tax is avoided by treating the SPE as a pass-through entity with 

income allocated and taxed to its owners.37

The current proposal by the industry representatives would create a 

structure similar to a Real Estate Mortgage Investment Conduit (REMIC)38

or a Financial Asset Securitization Investment Trust (FASIT). REMICs and 

FASITs are pools of real property mortgages or debt instruments that issue 

multiple classes, or tranches, of financial payments among investors. The 

REMIC and FASIT legislation adopt two approaches to avoiding an issuer 

tax: They treat the issuer as a pass-through entity and classify regular 

interest as debt for purposes of allowing an interest deduction to the issuer. 

The proposal would mimic REMICs and FASITs by providing pass-through 

treatment for the onshore SPRV and ensuring that the regular payments in 

the SPRV are classified as debt. To the extent that domestic SPRVs gained 

business at the expense of taxable entities, the federal government could 

experience tax revenue losses. The statutory and regulatory requirements 

used to implement any such legislation would also affect tax revenue. 

37The principal types of mortgage or other asset-backed securities currently available are 

pass-through certificates, pay-through bonds, equity interests in domestic issuers of paythrough bonds, pass-through debt certificates, and Real Estate Mortgage Investment 

Conduits and Financial Asset Securitization Investment Trusts interests. Offshore 

corporations also are used to issue some asset-backed securities. See David Nirenberg, Tax 

Developments in Securitization, 829 PLI/Comm 411, 2001.

38Several concerns with the use of pass-through certificates and pay-through bonds arose, 

including the inability of a grantor trust to issue pass-through certificates that are divided 

into multiple classes with staggered maturities. To address some of these concerns, the Tax 

Reform Act of 1986 enacted the REMIC rules. 
Page 28 GAO-02-941 Risk-Linked Securities

Expanded use of catastrophe bonds might occur with favorable 

implementing requirements, but such legislative actions may also create 

pressure from other industry sectors for similar tax treatment. 

Also, some elements of the insurance industry believe that any 

consideration of changes to the tax treatment of domestic SPRVs would 

have to take into account the taxation of domestic reinsurance companies. 

Domestic reinsurance companies are taxed under the special rules of 

Subchapter L of the Internal Revenue Code. Under these rules, all 

insurance companies are taxed as corporations. Premiums earned by a 

domestic reinsurance company, after deducting premiums paid for 

retrocessional insurance coverage, are taxable. Investment income earned 

by the reinsurer is also taxable. A ceding commission paid by a reinsurer to 

an insurer to cover costs, including marketing and sale of the premium, is 

taxable to the ceding insurance company. However, many reinsurers are 

either incorporated offshore or are affiliated with companies created 

offshore to take advantage of reduced levels of taxation. Payments to an 

offshore reinsurer may be subject to an excise tax.39 In addition, because of 

the potential for abuses, the Secretary of the Treasury has special statutory 

authority to reallocate deductions, assets, and income between unrelated 

parties when a reinsurance transaction has a significant tax avoidance 

effect.40

RAA officials expressed concerns about the impact of NAIC’s model act 

creating an onshore SPRV. RAA objects to both the special regulatory 

treatment in the model act and the tax advantages proposed for the 

onshore SPRV. RAA argues that the NAIC model act creates a new class of 

reinsurer that will operate under regulatory and tax advantages not 

afforded to existing U.S. licensed and taxed reinsurance companies. RAA 

maintains that the SPRV will act as a reinsurer and yet not be subject to 

insurance regulation, thus endangering solvency regulation and creating an 

uneven playing field for reinsurers.

3926 U.S.C. §4371.

4026 U.S.C. §845.
Page 29 GAO-02-941 Risk-Linked Securities

Risk-Linked Securities Do 

Not Have Broad Investor 

Participation

Catastrophe bonds have not attracted a wide range of investors beyond 

institutional investors. Investor participation in risk-linked securities is 

limited in part because the risks of these securities are difficult to assess. 

Investment bank representatives and investment advisors we interviewed 

noted that catastrophe bonds have thus far been issued only to 

sophisticated institutional investors and a small number of large 

investment fund managers for inclusion in bond portfolios that include 

noninvestment-grade bonds. Most catastrophe bonds carry noninvestmentgrade bond ratings from the rating agencies, but a low rating by itself has 

not been a barrier to active investor interest in other types of bonds, such 

as corporate bonds. The investment fund managers told us that catastrophe 

bonds comprise 3 percent or less of the portfolios in which they are 

included. On the one hand, the managers like the diversification aspects of 

catastrophe bonds because the risks are generally uncorrelated with the 

credit risks of other parts of the bond portfolio. On the other hand, 

managers stated that they have concerns about the limited liquidity and 

track record of catastrophe bonds as well as the lack of in-house expertise 

to understand the perils, indexes, and other features of the bonds.41

As requested, we explored the potential for individual investors to 

purchase shares in mutual funds that purchase catastrophe bonds for 

inclusion with other securities in a mixed asset fund. We analyzed the SEC 

rules governing catastrophe bond issuance and mutual fund composition 

and confirmed with SEC that these rules and regulations do not preclude 

mutual funds from purchasing catastrophe bonds. One of the investment 

advisors we interviewed told us that his firm included a small amount of 

catastrophe bonds in mutual funds sold to the public. However, a mutual 

fund industry association official told us that the mutual fund companies 

that the association surveyed—including three of the largest—have not 

included catastrophe bonds in funds available to individual investors 

because the companies lack the capacity to evaluate the risks. The mutual 

fund industry official also raised the issue of whether the risk associated 

with risk-linked securities would be appropriate or suitable for investments 

by a broad range of investors, including moderate-income investors.

41The September 9, 2002, comment letter from RAA notes that no catastrophe bond 

contracts have been triggered by catastrophic events. 
Page 30 GAO-02-941 Risk-Linked Securities

Agency Comments and 

Our Evaluation

We received written comments on a draft of this report from NAIC, RAA, 

and BMA. We also obtained technical comments from Treasury, SEC, 

CFTC, NAIC, RAA, and BMA that have been incorporated where 

appropriate. NAIC commented that it supports developing alternative 

sources of reinsurance capacity, the securitizing of catastrophic risk within 

the United States, and subjecting SPRVs to U.S. insurance regulation. As 

stated in our report, a group of insurance industry representatives 

interacting with NAIC’s working group on securitization is considering how 

to structure a legislative proposal to make the onshore SPRV a tax-exempt 

entity. Our report also indicates that such legislation also could result in tax 

revenue losses and other potential costs. NAIC stated that SPRVs, however, 

would be subject to onshore supervision by U.S. regulators, but it is not 

clear to us how risk-linked securities would actually be regulated once 

brought onshore.42

RAA commented that our report provides an excellent summary on the use 

of risk-linked securities in providing coverage for catastrophes. However, 

RAA took exception to (1) our characterization of reinsurance industry 

capacity and (2) our description of risk-linked securities as an alternative 

to reinsurance. RAA noted that in recent occurrences of major catastrophic 

events in the United States, insurers and reinsurers had sufficient capital to 

meet their obligations and added that most of the California and Florida 

market was underwritten by insurers that relied very little, if at all, on 

reinsurance capacity. First, we note that while the reinsurance industry has 

been able to meet its obligations from recent events with existing capacity, 

the industry’s capacity must be considered along with issues related to (1) 

the price and availability of catastrophic reinsurance in high-risk areas and 

(2) its ability to handle multiple, sequential catastrophes. Some insurers 

who self-reinsure might do so partially because they believe that the price 

of reinsurance to cover their exposure to catastrophic events is not 

attractive. Second, RAA asked that we characterize risk-linked securities as 

a supplement to reinsurance rather than as an alternative because of the 

relatively small amount of reinsurance coverage currently provided 

through risk-linked securities. We agree, and our report states that risklinked securities add to or supplement reinsurance capacity, but we also 

42In one case, companies experienced an estimated $1 to $2 billion in losses in reinsuring the 

occupational accident portion of workers’ compensation insurance policies. See GAO-01-

977T.
Page 31 GAO-02-941 Risk-Linked Securities

note that sponsors of catastrophe bonds view these securities as 

alternatives to traditional reinsurance when they are more cost-effective. 

BMA stated that our report was accurate and well-researched and 

commented on several policy issues raised in the report. Their letter raised 

several concerns with our discussion of tax treatment, accounting 

treatment, and investor interest in risk-linked securities. First, BMA 

disagreed with concerns cited in our report that pass-through tax treatment 

for risk-linked securities could result in (1) tax revenue losses and

(2) regulatory and tax advantages that are not afforded to existing U.S.-

licensed and taxed reinsurance companies. BMA commented that because 

a large percentage of entities that provide reinsurance coverage is based 

outside of the United States, including all reinsurance companies 

established since September 11, 2001, the tax impact would not be 

dramatic. In addition, BMA noted that any potential loss of U.S. tax revenue 

must be weighed against the policy benefits associated with creating 

additional private-sector capacity to absorb and distribute insurance risk. 

We agree that many reinsurance entities are not U.S.-based, but the 

potential tax revenue losses would depend on a number of factors, 

including business lost by taxable entities and the regulatory requirements 

used to implement such legislation. We also agree that many considerations 

must be weighed in the policy decision to grant special tax treatment for 

onshore SPRVs, including potential tax revenue losses and the extent to 

which an uneven playing field is created for domestic reinsurance 

companies.

Second, BMA commented that our description of FASB’s SPE consolidation 

proposal was not based on the final exposure draft and that they interpret 

the proposal to allow SPRVs to apply only a variable interests approach and 

not satisfy a particular outside equity threshold. Our draft report discussion 

of the FASB proposal was based on the final exposure draft. While we did 

not evaluate BMA’s interpretation of the FASB proposal, we included their 

position in our report. Finally, BMA commented that our discussion of 

reasons for the lack of broader investor participation in risk-linked 

securities was incomplete and somewhat inaccurate. They noted that 

several mutual funds have purchased risk-linked securities as part of their 

overall portfolios, that mutual fund managers are well-equipped to evaluate 

the risk associated with these securities, and that lack of broader investor 

participation may be due to limited issuance. We agree that some mutual 

funds have purchased risk-linked securities and that lack of broader 

participation may be attributed to some degree to limited issuance of risklinked securities. However, information we obtained indicates that some of 
Page 32 GAO-02-941 Risk-Linked Securities

the largest mutual fund companies did not include risk-linked securities in 

their mutual fund portfolios mainly because of their unusual and unfamiliar 

risk characteristics. 

Unless you publicly announce its contents earlier, we plan no further 

distribution of this report until 30 days from the date of this letter. At that 

time, we will send copies of this report to the Ranking Minority Member of 

the House Committee on Financial Services and the Chairmen and Ranking 

Minority Members of the Senate Committee on Banking, Housing and 

Urban Affairs; and the House Committee on Ways and Means. We also will 

make copies available to others upon request. In addition, this report will 

be available for no charge on GAO’s Internet home page at 

http://www.gao.gov.

Please contact Bill Shear, Assistant Director, or me at (202) 512-8678 if you 

or your staff have any questions concerning this report. Key contributors to 

this work were Rachel DeMarcus, Lynda Downing, Patrick Dynes, Christine 

Kuduk, and Barbara Roesmann. 

Sincerely yours,

Davi M. D’Agostino

Director, Financial Markets and

Community Investment
Page 33 GAO-02-941 Risk-Linked Securities

Appendix I

Scope and Methodology ApApenednxidexiIs

You asked us to report on the potential for risk-linked securities to cover 

catastrophic risks arising from natural events. As agreed with your office, 

our objectives were to (1) describe catastrophe risk and how insurance and 

capital markets provide for insurance against such risks; (2) describe how 

risk-linked securities, particularly catastrophe bonds, are structured; and 

(3) analyze how key regulatory, accounting, tax, and investor issues might 

affect the use of risk-linked securities.

Even though we did not have audit or access-to-records authority with the 

private-sector entities, we obtained extensive documentary and testimonial 

evidence from a large number of entities, including insurance and 

reinsurance companies, investment banks, institutional investors, rating 

agencies, firms that develop models to analyze catastrophic risks, 

regulators, and academic experts. However, we did not verify the accuracy 

of data provided by these entities. Some entities we met with voluntarily 

provided information they considered to be proprietary, and therefore we 

did not report details from such information. In other cases, companies 

decided not to provide proprietary information, and this limited our inquiry. 

For example, we did not obtain any reinsurance contracts representing 

either traditional reinsurance or reinsurance provided through issuance of 

risk-linked securities. 

To describe catastrophe risk and how insurance and capital markets 

provide for insurance against such risks, we examined a variety of 

documents, including books on insurance and reinsurance; academic 

articles and essays; and analyses done by the Insurance Information 

Institute, the Insurance Services Office, modeling firms, and the 

Congressional Budget Office. We also interviewed officials from insurance 

companies, reinsurance companies, the California Earthquake Authority 

(CEA), the Florida Hurricane Catastrophe Fund (FHCF), modeling firms, 

and university finance departments and schools. 

To describe how risk-linked securities, particularly catastrophe bonds, are 

structured, we examined catastrophe bond-offering circulars, investment 

bank documents, reinsurance company analyses, rating agency reports, 

academic studies, futures exchange documents, and analyses prepared by 

the American Academy of Actuaries. We also met with officials of 

investment banks, insurance companies, reinsurance companies, rating 

agencies, modeling firms, a futures exchange, investment advisors, and the 

American Academy of Actuaries.
Appendix I

Scope and Methodology

Page 34 GAO-02-941 Risk-Linked Securities

To analyze how key regulatory, accounting, tax, and investor issues might 

affect the use of risk-linked securities, we examined a variety of 

documents, including books on insurance accounting and taxation, the 

Financial Accounting Standards Board’s (FASB) proposed consolidation 

principles for special-purpose entities, accounting firm publications, the 

National Association of Insurance Commissioners’ (NAIC) Statutory 

Accounting Principles, and the proceedings of NAIC’s Working Group on 

Securitization. We met with officials from many organizations, including 

NAIC’s Working Group on Securitization, the Bond Market Association 

(BMA), the Reinsurance Association of America, the Investment Company 

Institute—a mutual fund company association, and FASB. We also met with 

officials from the Securities and Exchange Commission (SEC), the 

Commodity Futures Trading Commission (CFTC), and the Department of 

the Treasury (Treasury).

We faced a number of limitations in our work. We did not verify the 

accuracy of data provided by the various entities we contacted. While we 

obtained publicly available data on U.S. reinsurance prices, we could not 

obtain information to assess the reliability of the price data nor the 

methodology used to construct the reported price index. We obtained 

offering statements for some catastrophe bond offers. However, we could 

not determine whether the offering statements were representative of the 

universe of catastrophe bond offers, and we relied on summary 

information on the various offers provided to us by bond rating agencies. 

We also faced limitations in identifying the specific financing arrangements 

made to provide independent capital investments to special purpose 

reinsurance vehicles (SPRV) used to avoid consolidation with the sponsor’s 

balance sheet. In addition, without access to reinsurance contracts, we 

could not determine the extent to which insurance and reinsurance 

companies received credit for reinsurance, including those companies that 

relied, in part, on risk-linked securities to transfer catastrophe risk. 

Although we identified factors that industry and capital markets experts 

believe might cause the use of risk-linked securities to expand or contract, 

it was not within the scope of our work to forecast increased or reduced 

future use of these securities—either under current accounting, regulatory, 

and tax policies or under changed policies. It also was not within the scope 

of our work to take a position on whether the increased use of risk-linked 

securities is beneficial or detrimental.

We conducted our work between October 2001 and August 2002 in 

Washington, D.C.; Chicago, Ill.; New York, N.Y.; and various locations in 
Appendix I

Scope and Methodology

Page 35 GAO-02-941 Risk-Linked Securities

California and Florida, in accordance with generally accepted government 

auditing standards.
Page 36 GAO-02-941 Risk-Linked Securities

Appendix II

Catastrophe Options ApendxiI

Catastrophe options were offered by the Chicago Board of Trade (CBOT) in 

1995. These options contracts were among the first attempts to market 

natural disaster-related securities. Catastrophe options offered the 

advantage of standardized contracts with low transaction costs traded over 

an exchange. Specifically, the purchaser of a catastrophe option paid the 

seller a premium, and the seller provided the purchaser with a cash 

payment if an index measuring insurance industry catastrophe losses 

exceeded a certain level. If the catastrophe loss index remained below a 

specified level for the prescribed time period, the option expired worthless, 

and the seller kept the premium. The option might have been purchased by 

an insurance company that wanted to hedge its catastrophe risk and might 

have been sold by firms that would do well in the event of a catastrophe—

for example, homebuilders—or by investors looking for a chance to 

diversify outside of traditional securities markets. 

Catastrophe option contracts were revised several times and covered 

exposures on national, regional, and state bases. On the one hand, because 

the payouts on the contracts were based on an index of insurance industry 

catastrophe losses,43 the transactions did not expose the investor to moral 

hazard or adverse selection44 risk. The indexes used were the Property 

Claim Services45 (PCS) catastrophe loss indexes.46 On the other hand, the 

contracts created basis risk for purchasers—the differences in the claim 

patterns between an individual insurer’s portfolio and the industry index. 

The options were to have offered minimal credit risk because the CBOT 

clearinghouse guaranteed the transactions. However, low trading volumes 

on options also raised questions about liquidity risk. Trading in CBOT 

catastrophe options ceased in 1999 due to lower-than-expected demand; 

CBOT delisted catastrophe options in 2000.

43The payouts varied with industry catastrophe losses, limited to certain maximums.

44Adverse selection is the tendency of persons with a higher-than-average chance of loss to 

seek reinsurance at average rates, which, if not controlled by underwriting, results in higherthan-expected loss levels. 

45PCS, a unit of the Insurance Services Office, provides estimates of insured losses related to 

catastrophes incurred by the insurance industry. 

46The indexes track PCS’s estimates of the insurance industry’s aggregate direct property 

losses as a result of catastrophes.
Page 37 GAO-02-941 Risk-Linked Securities

Appendix III

California and Florida Approaches to 

Catastrophe Risk ApendxiI

The insurance markets in California and Florida illustrate the difficulties 

that the catastrophe insurance industry has faced nationally. Because 

California and Florida are markets with high catastrophe risk, these states 

have developed programs to increase insurer capacity in these markets. 

The Northridge earthquake raised serious questions about whether 

insurers could pay earthquake claims for any major earthquake. In 1994, 

insurers representing about 93 percent of the homeowners insurance 

market in California severely restricted or refused to write new 

homeowner policies because the insurers grew concerned that another 

earthquake would exhaust their resources. Florida experienced a similar 

insurance crisis after Hurricane Andrew in 1992. In response, the state 

created two organizations to provide primary insurance coverage and 

additional reinsurance capacity.

California Earthquake 

Authority Provides 

Insurance

In 1996, the California legislature established CEA as a privately funded 

and publicly managed entity to help residents protect themselves against 

earthquake loss. CEA sells earthquake insurance to homeowners, including 

condominium owners and renters. Insurers doing business in California 

must offer earthquake insurance in their homeowners insurance policies, 

whether a CEA policy or their own. The basic CEA policy carries a 

deductible of 15 percent on the home’s insured value, provides up to $5,000 

to replace contents and personal possessions, and up to $1,500 for 

emergency living expenses. In 2001, the average policy for a house cost 

$560, but costs were several times higher in areas with high seismic risk. 

While companies must offer earthquake insurance, there is no state 

requirement that consumers purchase earthquake insurance or that 

mortgage lenders require it. About 16 percent of California residences had 

earthquake insurance at the end of 2001, and CEA insured 65 percent of 

those with earthquake insurance.

As of January 2002, CEA had more than 814,000 policies and a claims 

paying capacity of more than $7 billion against an exposure from all 

policies of about $175 billion. Their claims paying capacity consisted of 

layers of capital, insurance company assessments, and reinsurance and a 

line of credit. Recent external and internal reviews—conducted by the 

California State Auditor, CEA staff, and others—of CEA’s finances have 

focused on its claims paying capacity. The common concern of these 

reviews has been the heavy dependence on the reinsurance market—some 

40 percent of CEA’s $7.2 billion claims paying capacity. Reviewers 

recommend that some of CEA’s claims paying capacity be converted to 

catastrophe bonds. Such a conversion would make CEA the largest 
Appendix III

California and Florida Approaches to 

Catastrophe Risk

Page 38 GAO-02-941 Risk-Linked Securities

catastrophe bond issuer in the world. As shown in figure 6, CEA is 

currently exploring catastrophe bond placements on two layers for $400 

million and $338 million. Recently the CEA’s Governing Board decided not 

to support CEA issuance of catastrophe bonds because catastrophe bonds 

are done in offshore tax havens. A CEA official told us that the Governing 

Board would revisit the issue when catastrophe bonds can be done 

onshore.

Figure 6: Current and Proposed California Earthquake Authority Financial Structure

Source: California Earthquake Authority.

Florida Provides 

Residential Coverage 

for Windstorms and 

Supplements Insurance 

Capacity

Following Hurricane Andrew in 1992, there was a property insurance crisis, 

and the Florida state legislature created two organizations to provide 

coverage and additional capacity—the Florida Residential Joint 

Underwriting Association (JUA) and the FHCF. JUA provides residential 

coverage in specifically designated areas that are most vulnerable to 

windstorm damage. Qualified recipients are property owners who could 

not obtain coverage from private insurers after Hurricane Andrew. The JUA 
Appendix III

California and Florida Approaches to 

Catastrophe Risk

Page 39 GAO-02-941 Risk-Linked Securities

had 68,000 policyholders and an $11 billion exposure as of January 2001. 

Rates charged by the JUA in each county must be at least as high as the 

highest rate charged by the 20 largest private insurance companies in 

Florida. The JUA’s capacity to pay claims was $1.9 billion as of January 

2001; claims would be paid by drawing down its surplus, private 

reinsurance, assessments of members, pre-event notes, a line of credit, and 

reimbursements from the state’s catastrophe fund. In March 2002, the 

Florida legislature approved a plan to merge JUA with the Florida 

Windstorm Underwriting Association (FWUA), thereby forming an 

organization called the Citizen’s Property Insurance Corporation.47

The FHCF was created as a source of reinsurance capacity to supplement 

what was available from private sources. The FHCF is run by Florida and 

was set up to encourage insurers to stay in the Florida marketplace in the 

aftermath of Hurricane Andrew, when reinsurance became more difficult to 

obtain. The FHCF reimburses insurers for a portion of their claims from 

future severe hurricanes. Unlike California, where catastrophe coverage is 

voluntary, Florida homeowners’ policies must include hurricane coverage. 

The FHCF is the world’s largest hurricane reinsurer, and Florida’s two 

residential pools (JUA and FWUA) and private insurers depend on it. 

Participation by the state’s insurers is mandatory, but insurers may choose 

different levels of coverage (45 percent, 75 percent, or 90 percent) above a 

high-retention or deductible level for the participating insurers. The fund is 

financed by (1) about 260 property insurers doing business in the state on 

the basis of their exposure to hurricane loss and (2) bonding secured by 

emergency assessments on other insurers. If the FHCF cash balance is not 

sufficient to reimburse covered losses, it can issue tax-exempt revenue 

bonds, which are financed by an emergency assessment of all propertycasualty insurers excluding workers’ compensation writers. Premiums paid 

relative to coverage purchased are significantly below those in the privatesector. The FHCF’s capacity is currently $11 billion against an exposure of 

over $1 trillion. The $11 billion capacity comprises approximately

$4.9 billion in cash and $6.1 billion in borrowing capacity. FHCF is also 

exempt from federal income tax. Although no major claims have occurred 

since Hurricane Andrew, the FHCF is designed to handle a $16.3 billion 

ground up residential property loss, which would include its $11 billion

47The FWUA was created in the 1970s to provide wind coverage to property owners who 

cannot obtain hurricane and windstorm coverage from private insurance companies. It has 

430,000 policies with an exposure exceeding $90 billion.
Appendix III

California and Florida Approaches to 

Catastrophe Risk

Page 40 GAO-02-941 Risk-Linked Securities

current capacity limit along with an aggregate insurance industry retention 

of $3.8 billion and an aggregate copayment by insurers of about $1.5 billion.

Florida has not announced plans to use risk-linked securities to address 

capacity issues.
Page 41 GAO-02-941 Risk-Linked Securities

Appendix IV

Statutory Accounting Balance Sheet 

Implications of Reinsurance Contracts ApendxiIV

Over the term of insurance policies, premiums that an insurance company 

collects are expected to pay for any insured claims and operational 

expenses of the insurer while providing the insurance company with a 

profit. The amount of projected claims that a single insurance policy may 

incur is estimated on the basis of the law of averages. An insurance 

company can obtain indemnification against claims associated with the 

insurance policies it has issued by entering into a reinsurance contract with 

another insurance company, referred to as the reinsurer. The original 

insurer, referred to as the ceding company, pays an amount to the reinsurer, 

and the reinsurer agrees to reimburse the ceding company for a specified 

portion of the claims paid under the reinsured policy. 

Reinsurance contracts can be structured in many different ways. 

Reinsurance transactions over the years have increased in complexity and 

sophistication. Reinsurance accounting practices are influenced not only 

by state insurance departments through NAIC, but also by SEC and FASB. 

If an insurer or reinsurer engages in international insurance, both 

government regulatory requirements and accounting techniques will vary 

widely among countries.

Statutory Accounting Principles promulgated by NAIC allow an insurance 

company that obtains reinsurance to reflect the transfer of risk for 

reinsurance on the financial statements that it files with state regulators 

under certain conditions. The regulatory requirements for allowing credit 

for reinsurance are designed to ensure that a true transfer of risk has 

occurred and any recoveries from reinsurance are collectible. By obtaining 

reinsurance, ceding companies are able to write more policies and obtain 

premium income while transferring a portion of the liability risk to the 

reinsurer. Under many reinsurance contracts, a commission is paid by the 

reinsurer to the ceding company to offset the ceding company’s initial 

acquisition cost, premium taxes and fees, assessments, and general 

overhead. For example, if an insurer would like to receive reinsurance for 

$10 million and negotiates a 20 percent ceding commission, then the 

insurer will be required to pay the reinsurer $8 million ($10 million 

premiums ceded, less $2 million ceding commission income). The effect of 

this transaction is to reduce the ceding company’s assets by the $8 million 

paid for reinsurance, while reducing the company’s liability for unearned 

premiums by the $10 million in liabilities transferred to the reinsurer. The 

$2 million is recorded by the ceding company as commission income. This 

type of transaction results in an economic benefit for the ceding company 

because the ceding commission increases equity. The reinsurer has 

assumed a $10 million liability and would basically report a mirror entry 
Appendix IV

Statutory Accounting Balance Sheet 

Implications of Reinsurance Contracts

Page 42 GAO-02-941 Risk-Linked Securities

that would have the opposite effects on its financial statements. Figure 7 

shows the effects of the reinsurance transaction on both the ceding 

insurance company and reinsurance company’s balance sheets and is 

intended to show how one transaction increases and decreases assets and 

liabilities.48

Figure 7: Effect on Ceding and Reinsurance Companies’ Balance Sheets before and 

after a Reinsurance Transaction

Source: Insurance Accounting Systems Association.

48Whereas it appears that the ceding company increases its policyholders’ surplus, this 

transaction does not include the effects of other normal business transactions that will 

cause the surplus to decrease.
Appendix IV

Statutory Accounting Balance Sheet 

Implications of Reinsurance Contracts

Page 43 GAO-02-941 Risk-Linked Securities

Reinsurance contracts do not relieve the ceding insurer from its obligation 

to policyholders. Failure of reinsurers to honor their obligations could 

result in losses to the ceding insurer.

An insurer may also obtain risk reduction from an SPRV that issues an 

indemnity-based, risk-linked security; the recovery by the insurer would be 

similar to a traditional reinsurance transaction. However, if an insurer 

chooses to obtain risk reduction from sponsoring a nonindemnity-based, 

risk-linked security issued through an SPRV, the recovery could differ from 

the recovery provided by traditional reinsurance. Even though the insurer 

is reducing its risk, the accounting treatment would not allow a reduction 

of liability for the premiums.
Page 44 GAO-02-941 Risk-Linked Securities

Appendix V

Comments from the National Association of 

Insurance Commissioners ApendxiV

NATIONAL ASSOCIATION OF INSURANCE COMMISSIONERS 

NAIC 

EXECUTIVE

HEADQUARTERS

2301 MCGEE STREET

SUITE 800

KANSAS CITY MO

64108-2662

VOICE 816-842-3600

FAX 816-783-8175

FEDERAL AND

INTERNATIONAL

 RELATIONS

HALL OF THE STATES

444 NORTH CAPITOL ST NW

SUITE 701

WASHINGTON DC

20001-1509

VOICE 202-624-7790

FAX 202-624-8579

SECURITIES

VALUATION

OFFICE

1411 BROADWAY

9TH FLOOR

NEW YORK NY

10018-3402

VOICE 212-398-9000

FAX 212-382-4207

WORLD

WIDE WEB

www.naic.org

Ms. Davi M. D’Agostino 

Director, Financial Institutions and Community Investment 

United States General Accounting Office 

Washington, DC 20548 

 September 9, 2002 

Dear Ms. D’Agostino: 

Thank you for giving the NAIC the opportunity to comment on the report 

“Catastrophe Insurance Risks: the Role of Risk-Linked Securities and Factors 

Affecting Their Use”. 

The National Association of Insurance Commissioners (NAIC) is a voluntary 

organization of the chief insurance regulatory officials of the 50 states, the 

District of Columbia and four U.S. territories. The association’s overriding 

objective is to assist state insurance regulators in protecting consumers and 

helping maintain the financial stability of the insurance industry by offering 

financial, actuarial, legal, computer, research, market conduct and economic 

expertise. 

The NAIC formed a working group on Insurance Securitization in 1998 to 

“investigate whether there needs to be a regulatory response to continuing 

developments in insurance securitization, including the use of non-U.S. special 

purpose vehicles and to prepare educational material for regulators.” As a result 

of its deliberations, the NAIC has taken the position that U.S. insurance 

regulators should encourage the development of alternative sources of capacity 

such as insurance securitizations and risk linked securities as long as such 

developments are commensurate with the overriding goal of the NAIC 

membership of consumer protection. As such, the NAIC believes that one goal 

should be to encourage and facilitate securitizations within the United States. If 

transactions that are currently performed offshore were brought back to the 

United States, they would be subject to on-shore supervision by U.S. regulators. 

Both the NAIC’s Special Purpose Reinsurance Vehicle Model Act and the 

Protected Cell Company Model Act would require that at least one U.S. 

insurance commissioner would review each transaction in depth and set the 

appropriate standards. In addition, an NAIC member chairs the International 

Association of Insurance Supervisors’ Subgroup on Insurance Securitization 

and fully agrees with these views. 

At present, off-shore insurance securitizations are not subject to U.S. regulation, 

and the NAIC members are concerned about the appropriate use of Special 
Appendix V

Comments from the National Association of 

Insurance Commissioners

Page 45 GAO-02-941 Risk-Linked Securities

Purpose Vehicles. The recent events at Enron have demonstrated how 

inappropriate use of special purpose vehicles can endanger solvency. The NAIC 

membership believes that, properly used and structured, Special Purpose 

Reinsurance Vehicles may provide extra capacity, more competition, and may 

reduce the overall costs of insurance for the public. The NAIC membership 

therefore believes that on-shore SPRVs, regulated by U.S. insurance regulators, 

would be preferable to the current situation where most securitizations are 

conducted off-shore. 

Again, we thank you for the opportunity to review and comment on the report. 

Sincerely, 

Therese M. Vaughan 

President, NAIC 

Iowa Insurance Commissioner 
Page 46 GAO-02-941 Risk-Linked Securities

Appendix VI

Comments from the Reinsurance Association 

of America ApendxiVI

Note: GAO comments 

supplementing those in 

the report text appear 

at the end of this 

appendix.
Appendix VI

Comments from the Reinsurance Association 

of America

Page 47 GAO-02-941 Risk-Linked Securities
Appendix VI

Comments from the Reinsurance Association 

of America

Page 48 GAO-02-941 Risk-Linked Securities

See comment 1.

See comment 2.

See comment 3.

Now on p. 5.

See comment 4.

Now on p. 18.

See comment 5.
Appendix VI

Comments from the Reinsurance Association 

of America

Page 49 GAO-02-941 Risk-Linked Securities

The following are GAO’s comments on the Reinsurance Association of 

America’s letter dated September 9, 2002.

GAO Comments 1. In appendix III of the draft report we had already noted that the Florida 

Hurricane Catastrophe Fund provides reinsurance to supplement that 

available from private sources. We added a footnote on page 15 to note 

that reinsurance is also available from private sources for property and 

casualty insurance companies doing business in Florida. 

2. We agree and have added a footnote on page 29 to state that no 

catastrophe bond contracts have been triggered by an actual event. 

3. We agree and have added a footnote on page 14 on the creation of the 

Bermuda reinsurance market and its role in introducing new capacity 

into the marketplace after a major event. 

4. This issue is covered on pages 24 through 26. 

5. Bankruptcy remoteness is among the reasons that the special purpose 

entities are established, whether domestically or offshore.
Page 50 GAO-02-941 Risk-Linked Securities

Appendix VII

Comments from the Bond Market Association ApendxiVI

Note: GAO comments 

supplementing those in 

the report text appear 

at the end of this 

appendix.
Page 51 GAO-02-941 Risk-Linked Securities

Appendix VII

See comment 1.
Appendix VII

Comments from the Bond Market Association

Page 52 GAO-02-941 Risk-Linked Securities
Appendix VII

Comments from the Bond Market Association

Page 53 GAO-02-941 Risk-Linked Securities
Appendix VII

Comments from the Bond Market Association

Page 54 GAO-02-941 Risk-Linked Securities

See comment 2.
Appendix VII

Comments from the Bond Market Association

Page 55 GAO-02-941 Risk-Linked Securities

See comment 3.
Appendix VII

Comments from the Bond Market Association

Page 56 GAO-02-941 Risk-Linked Securities

Now on p.17.

See comment 4.

Now on p. 4.

See comment 5.

Now on pp. 5 and 18.

See comment 6.

Now on p. 17.

See comment 7.

Now on p. 17.

See comment 8.

Now on p. 18.

See comment 9.
Appendix VII

Comments from the Bond Market Association

Page 57 GAO-02-941 Risk-Linked Securities

Now on p. 21.

See comment 10.

Now on pp. 37 and 38.

See comment 11.
Appendix VII

Comments from the Bond Market Association

Page 58 GAO-02-941 Risk-Linked Securities

The following are GAO’s comments on the Bond Market Association’s letter 

dated September 10, 2002.

GAO Comments 1. Our report does not assign relative weights to the factors that lead to 

risk-linked securities being established offshore. We have added a 

footnote on page 21 to indicate that BMA believes that the principal 

reason risk-linked securities are organized offshore is to avoid taxation.

2. In contrast to BMA’s view, we state that a primary reason for limited 

investor participation in risk-linked securities is that the risks of these 

securities are difficult to assess. Also, the risks of risk-linked securities 

and mortgage-backed securities are assessed differently. For example, 

the risk of loss from a natural catastrophic event, such as an earthquake 

in a specified geographic area over a specified time period, is often 

based on events that will only happen once over a long-time horizon 

and in some cases as long as an 100-year period. Therefore, investors 

must rely heavily on complex scientific analysis of the likelihood of the 

event, rather than statistical modeling. In contrast, the risk of loss from 

events such as defaults on home mortgage payments by borrowers 

occurs frequently, and extensive statistics are available to assess such 

risks. 

3. We agree and our draft report discussed the relationship between 

reinsurance prices and interest in risk-linked securities as alternatives 

to traditional reinsurance. We also agree and have added a footnote on 

page 15 to indicate that U.S. reinsurance prices are influenced by 

catastrophic events outside of the United States. 

4. We did not order by relative importance the reasons insurance 

companies stated for their interest in risk-linked securities. 

5. We have changed the text on page 4 by inserting the word “generally.”

6. In our analysis, we relied on information provided by rating agencies 

for our discussion of credit ratings. Our draft report indicated that 

some catastrophe bonds contain tranches that have received 

investment-grade ratings. We added language to a footnote on page 18 

to note BMA’s statement that some newly issued, risk-linked securities 

have been investment grade. 
Appendix VII

Comments from the Bond Market Association

Page 59 GAO-02-941 Risk-Linked Securities

7. We have added language to a footnote on page 17 to note BMA’s 

statement that about $6 to $7 billion in catastrophe related, risk-linked 

securities were issued during this time period.

8. We have added a footnote on page 17 that states BMA’s view that there 

are often compelling reasons for sponsors of risk-linked securities to 

use nonindemnity-based structures. 

9. On the basis of information we obtained from the CBOT and market 

participants, our draft report stated that the options were to have 

offered minimal credit risk because the Board of Trade Clearing 

Corporation guaranteed the transactions. There were several reasons 

why catastrophe options had limited appeal, including daily marking to 

market, difficulties in accounting for options trading in insurance 

company accounting, basis risk, the unfamiliarity of locals with the 

product, lack of insurance company membership at CBOT, lack of 

investment by CBOT, the structure of the contract, lack of liquidity, and 

other factors. 

10. We have added language to a footnote on page 21 saying that bonds are 

rated according to frequency of loss as well as expected loss. As stated 

in our draft report, rating agencies provide bond ratings on the basis of 

their assessment of loss probabilities and financial severity. We use the 

term expected loss to mean the outcome from analyzing frequency of 

loss and expected loss when it occurs. 

11. We added language in appendix III that the Governing Board of the 

California Earthquake Authority has not authorized use of catastrophe 

bonds because of concerns about the appearance of being involved in 

offshore transactions in tax havens.

(250053)
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Public Affairs Jeff Nelligan, managing director, NelliganJ@gao.gov (202) 512-4800

U.S. General Accounting Office, 441 G Street NW, Room 7149 

Washington, D.C. 20548